Monday, 8 April 2013

I believe it's no wonder that our world is in trouble. We
currently lack the global systems science needed to understand our world, which
is now changing more quickly than we can collect the experience required to
cope with upcoming problems. We can also not trust our intuition, since the
complex systems we have created behave often in surprising, counter-intuitive
ways. Frequently, their properties are not determined by their components, but
their interactions. Therefore, a strongly coupled world behaves fundamentally
different from a weakly coupled world with independent decision-makers. Strong
interactions tend to make the system uncontrollable – they create cascading
effects and extreme events.

As a consequence of the transition to a more and more
strongly coupled world, we need to revisit the underlying assumptions of the
currently prevailing economic thinking. In the following, I will discuss 10
widespread assertions, which would work in a perfect economic world with
representative agents and uncorrelated decisions, where heterogeneity, decision
errors, and time scales do not matter. However, they are apparently not well
enough suited to depict the strongly interdependent, diverse, and quickly changing
world, we are facing, and this has important implications. Therefore, we need
to 'think out of the box' and require a paradigm shift towards a new economic
thinking characterized by a systemic, interaction-oriented perspective inspired
by knowledge about complex, ecological, and social systems. As Albert Einstein
noted, long-standing problems are rarely solved within the dominating paradigm.
However, a new perspective on old problems may enable new mitigation
strategies.

1. More networking is good and reduces risks

Many human-made systems and services are based on
networking. While some degree of networking is apparently good, too much
connectivity may also create systemic risks and pathways for cascading effects.
These may cause extreme events and global crises like the current financial
crisis.

Moreover, in social dilemma situations (where unfair
behavior or cheating creates individual benefits), too much networking creates
a breakdown of cooperation and trust, while local or regional interactions may
promote cooperation. The transformation of the financial system into a global
village, where any agent can interact with any other agent, may actually have
been the root cause of our current financial crisis.

Current economic thinking is based on the assumption that
the economic system is in equilibrium or at least tends to develop towards a
state of equilibrium. However, today's world changes faster than many companies
and policies can adapt. Therefore, the world economic system is unlikely to be
in equilibrium at any point in time. It is rather expected to show a complex
non-equilibrium dynamics.

Therefore, a new economic thinking inspired by complex
dynamical systems, ecosystems, and social systems would be beneficial. Such a
perspective would also have implications for the robustness of economic
systems. Overall, beneficial properties seem to be: redundancy, variety,
sparseness, decoupling (separated communities, niches), and mutually adjusted
time scales (which are required for hierarchical structures to function well).

The 'homo economicus' is a widely used paradigm in
economics. It is the basis of a large and beautiful body of mathematical proofs
on idealized economic systems. However, the paradigm of a strictly optimizing,
perfect egoist is a model, which is questioned by theoretical and empirical
results.

Theoretically, the paradigm assumes unrealistic information
storage and processing capacities (everyone would need to have a full 1:1
representation of the entire world in the own brain and an instant data
processing of huge amounts of data, including the anticipation of future
decisions of others). Empirically, one finds that people behave in a more
cooperative and fair way than the paradigm of the 'homo economicus' predicts.
In particular, the paradigm neglects the role of errors, emotions,
other-regarding preferences, etc. This implies significant deviations of real
human behaviors from theoretically predicted ones.

Another pillar of conventional economic thinking is Adam
Smith's principle of the 'invisible hand', according to which selfish profit
maximization would automatically lead to the best systemic outcome based on
self-organization. It is the basis of the ideology of 'free markets', according
to which regulation would tend to reduce the performance of economic systems.

However, models in evolutionary game theory show that
self-organized coordination in markets can easily fail, even when market
participants have equal power, symmetrical information etc. Moreover, even if
the individually optimal behavior also maximizes system performance and if
everybody behaves very close to optimal, this may still create a systemic
failure (e.g. when the system optimum is unstable). Therefore, it is highly
questionable whether the systemic inefficiencies resulting from individual
optimization efforts can always be compensated for by greedy motivations (such
as trying to get more than before or more than others).

Countermeasures: Measure the system state in real-time and
respond to this information adaptively in a way that promotes coordination and
cooperation with the interaction partners. Create an information and
communication system supporting collective (self-)awareness of the impact of
human actions on our world. Increase opportunities for social, economic and political
participation.

5. Financial markets are efficient

One implication of Adam Smith's principle of the 'invisible
hand' is the efficiency of financial markets, according to which any
opportunity to make money with a probability higher than chance would
immediately be used, thereby eliminating such opportunities and any related
market inefficiencies.

Efficient markets should not create bubbles and crashes, and
therefore one would not need contingency plans for financial crises (they could
simply not occur). Financial markets would rather be in equilibrium as the
conventional Dynamic Stochastic General Equilibrium Models suggest. However,
many people believe that bubbles and crashes do occur. The flash crash of May
6, 2010, is a good example of a market irregularity, which has repeatedly
occurred in the meantime. Also, many financial traders do not seem to believe
in efficient markets, but rather in the existence of opportunities that can be
used to make over-proportional profits.

Countermeasures: Develop contingency plans for financial
crises. Adjust the financial architecture and identify suitable strategies
(such as breaking points) to stop cascading effects in the financial system.
Introduce noise into financial markets by random trading transactions to
destroy bubbles before they reach a critical size that may have a disastrous
systemic impact.

6. More information and financial innovations are good

One common view is that market inefficiencies result from an
unequal distribution of power, which partially results from information
asymmetries (“knowledge is power”). Therefore, providing more information to
everyone should remove the related inefficiencies.

However, too much information creates a cognitive
information overload. As a result, people tend to orient at other people's
behaviors and information sources they trust. As a consequence, people do not
anymore take independent decisions, which can undermine the 'wisdom of crowds'
and market efficiency. One example is the large and unhealthy impact that the
assessments of a few rating agencies have on the global markets.

It is also believed that financial innovations will make
markets more efficient by making markets more complete. However, it has been
shown that complete markets are unstable. In fact, leverage effects, 'naked'
short-selling (of assets one does not own), credit default swaps,
high-frequency trading and other financial instruments may have a destabilizing
effect on financial markets.

Countermeasures: Identify and pursue decentralized, pluralistic,
participatory information platforms, which support the 'wisdom of crowds'
effect. Test financial instruments (such as derivatives) for systemic impacts
(e.g. by suitable experiments and computer simulations) and certify them before
they are released, as this is common in other economic sectors (special safety
regulations apply, for example, in the electrical, automobile, pharmacy and
food sectors).

7. More liquidity is better

Another wide-spread measure to cure economic crises are
cheap loans provided by central banks. While this is intended to keep the
economy running and to promote investments in the real economy, most of this
money seems to go into financial speculation, since business and investment
banks are not sufficiently separated.

This can cause bubbles in the financial and real estate
markets, where much of these cheap loans are invested. However, the high
returns in the resulting 'bull markets' are not sustainable, since they depend
on the continued availability of cheap loans. Sooner or later, the created
bubbles will implode and the financial market will crash (the likelihood of
which goes up when the interest rates are increased). This again forces central
banks to reduce interest rates to a minimum in order to keep the economy going
and promote investments and growth. In other words, too much liquidity is as
much of a problem, as is too little.

The 'representative agent approach' is another important
concept of conventional economic thinking. Assuming that everyone would behave
optimally, as the paradigm of the 'homo economicus' predicts, in equivalent
situations everybody should behave the same. This allows one to replace the
interaction of an economic agent with other agents by interactions with average
agents, in particularly if one assumes that everyone has access to the same
information and participates in perfect markets.

However, the representative agent model cannot describe
cascade effects well. These are not determined by the average stability, but by
the weakest link. The 'representative agent approach' also neglects effects of
spatial interactions and heterogeneities in the preferences of market
participants. When these are considered, the conclusions can be completely
different, sometimes even opposite (e.g. there may be an 'outbreak' rather than
a breakdown of cooperative behavior).

Finally, the representative agent approach does not allow
one to understand particular effects of the interaction network structure,
which may promote or obstruct cooperativeness, trust, public safety, etc. Neglecting
such network effects can lead to a serious underestimation of the importance of
'social capital' for the creation of economic value and social well-being.

Countermeasures: Protect economic and social diversity.
Allow for the existence of niche markets and for the consideration of justified
local advantages. Avoid competition on one single dimension (e.g. economic
value generation) and promote multi-criterion incentive systems. Develop better
compasses for decision-making than GDP per capita, taking into account
environmental, health, and social factors. Make social capital (such as
cooperativeness, trust, public safety, …) measurable.

9. Regulation can fix the imperfections of economic systems

When the self-organization of markets does not work perfectly,
one often tries to 'fix the problem' by regulation. However, complex systems
cannot be steered 'like a bus', and many control attempts fail. In many cases,
the information required to regulate a complex system is not available, and
even if one would have a surveillance system that monitors all variables of the
system, one would frequently not know what the relevant control parameters are.
Besides, suitable regulatory instruments are often lacking.

A more promising way to manage complexity is to facilitate
or guide favorable self-organization. This is often possible by modifying the
interactions between the system components. It basically requires one to
establish targeted real-time information feedbacks, suitable 'rules of the
game', and sanctioning mechanisms. To stay consistent with the approach of
self-organization, sanctioning should as far as possible be done in a
decentralized, self-regulatory way (as it is characteristic for social norms or
the immune systems).

Countermeasures: Pursue a cybernetic and synergetic
approach, promoting favorable self-organization by small changes in the
interactions between the system elements, i.e. by fixing suitable 'rules of the
game' to avoid instabilities and suboptimal systemic states. (Symmetry,
fairness, and balance may be such principles.) Introduce a global but
decentralized and manipulation-resistant multi-criterion rating system,
community-specific reputation system, and pluralistic recommender system
encouraging rule-compatible behavior.

10. Moral behavior is always costly

Species that do not strictly optimize their benefits are
often assumed to disappear eventually due to the principles of natural
selection implied by the theory of evolution. As a consequence, a 'homo
economicus' should remain, and moral decision-making, which constrains oneself
to a subset of available options, would vanish.

This certainly applies, if one forces everybody to interact
with everybody else on equal footing, as the concept of perfect, free markets
demands. In fact, evolutionary game-theoretical models show that these are
conditions under which a 'tragedy of the commons' tends to occur, and where
cooperation, fairness and trust tend to erode. On the other hand, social
systems have found mechanisms to avoid the erosion of social capital. These
mechanisms include repeated interactions, reputation effects, community
interactions, group competition, sanctioning of improper behavior etc. In
particular, decentralized market interactions seem to support fairness.

Countermeasures: Promote value-sensitive designs of monetary
systems and information and communication systems. For example, introduce two
co-existing, interacting, competitive exchange systems: one for anonymous
(trans)actions (as we largely have them today) and one for accountable,
traceable (trans)actions (creating 'social' money or information).
Additionally, introduce suitable transaction costs to create incentives for
accountable, responsible (trans)actions and to promote ethical behavior.

Summary

In conclusion, we are now living in a strongly coupled and
strongly interdependent world, which poses new challenges. While it is probably
unrealistic to go back beyond the level of networking and globalization we have
reached, there is a great potential to develop new management approaches for
our complex world based on suitable interaction rules and adaptive concepts,
using real-time measurements.

It must be underlined that our current financial and
economic problems cannot be solved within the current economic mainstream
paradigm(s). We need to change our perspective on the financial and economic
system and pursue new policies. The following recommendations are made:

Adjust the perspective of our world to the fundamentally
changed properties of the globalized, strongly interdependent
techno-socio-economic-environmental system we have created and its resulting
complex, emergent dynamic system behavior.

Make large-scale investments into new economic thinking,
particularly multi-disciplinary research involving knowledge from sociology,
ecology, complexity science, and cybernetics.

Support diversity in the system, responsible innovation, and
multi-dimensional competition.

Recognize the benefits of local and regional interactions
for the creation of social capital such as cooperativeness, fairness, trust,
etc.

Require an advance testing of financial instruments and
innovations for systemic impacts and restrict destabilizing instruments.

Identify and establish a suitable institutional framework
for interactions (suitable 'rules of the game') in order to promote a favorable
self-organization.

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The activities leading to these results has received funding from the European Union Seventh Framework Programme (FP7/2007-2013) under grant agreement n° 284709 - project 'FuturICT', a Coordination and Support Action in the Information and Communication Technologies activity area